Lecture 6 Efficient Markets and Excess Volatility.ppt

Lecture 6: Efficient Markets and Excess Volatility The Efficient Markets Hypothesis History of the Hypothesis Reasons to think markets are efficient Reasons to doubt markets are efficient Technical analysis Empirical evidence in literature Homework assignment and regressions Earliest Known Statement “When shares become publicly known in an open market, the value which they acquire there may be regarded as the judgement of the best intelligence concerning them.” - George Gibson, The Stock Exchanges of London Paris and New York, G. P. Putnman Sons, New York, 1889 Intuition of Efficiency Reuter’s pigeons and the telegraph Beepers the internet Must be hard to get rich Textbook Version Today As one of the six most important ideas in finance: “Security prices accurately reflect available information, and respond rapidly to new information as soon as it becomes available” Richard Brealey Stewart Myers, Principles of Corporate Finance, 1996 Harry Roberts, 1967 Weak form efficiency: prices incorporate information about past prices Semi-strong form: incorporate all publicly available information Strong form: all information, including inside information Price as PDV of Expected Dividends If earnings equal dividends and if dividends grow at long-run rate g, then by growing consol model P=E/(r-g), P/E=1/(r-g). (Gordon Model) So, efficient markets theory purports to explain why P/E varies across stocks PEG ratio is popular indicator = g’/(P/E), where g’ is short-run growth rate; popular rule of thumb: buy if PEG0.5 PEG rule of thumb makes sense only if g’ bears a certain relation to g; not a sensible rule. Efficient markets denies that any rule works Reasons to Think Markets Ought to Be Efficient Marginal investor determines prices Smart money dominates trading Survival of fittest Reasons to Doubt these Reasons Marginal investor: wealth matters Smart money: matter of degree. Limits to arbitrage theory Survival of fittest: life cycle renews Psychological Factors Gambling be